Domestic Innovation and Procurement

Recent developments have raised concern among foreign-invested enterprises that want to tap the country’s government procurement market.by US-China Business Council staffSome foreign companies in China have reported increasing difficulty in making sales to government entities in China—whether a government agency, school, hospital, or state-owned enterprise—in recent months. According to the US-China Business Council, some member companies attribute this difficulty to China’s emphasis on promoting the products of indigenous innovation. “Indigenous innovation” refers to products, technologies, and brands developed and owned by Chinese companies—and the measures that central-government agencies have taken to promote Chinese entities, seemingly at the expense of overseas companies and foreign-invested entities in China. These measures include local indigenous innovation catalogues and “buy local” regulations.

Indigenous innovation nuts and bolts

Policy goals

Indigenous innovation is a policy concept that the PRC government developed to boost the creation and commercialization of proprietary ideas and technologies by Chinese companies. It has been a core component of China’s economic development policy for several years. Central-government planners have often expressed their concern that the country’s economy and production capacity rely heavily on foreign technology. In their view, it is developmentally risky to have foreign-owned patents underlie much of China’s economic growth and to allow foreign brands to dominate the marketplace. As the country has advanced economically, some government planners have argued that Chinese-owned patents and trademarks should be the foundation of the country’s development.

At the center of China’s indigenous innovation drive is the Medium- and Long-Term National Plan for Science and Technology Development (2006-20) and a follow-up document on its supporting policies, both released by the State Council in 2006. The plan and its supporting policies formally introduced the concept of indigenous innovation into China’s national industrial policy and laid out several goals— chiefly, to develop a system to evaluate and qualify indigenous innovation products, establish a system to use government funds to buy such products, and give them preferential treatment in the government procurement process. The plan encouraged government agencies to work cooperatively to develop measures that would favor products that use Chinese-developed ideas and technology (see Box). Since then, several central- and local-government agencies have implemented preferential policies, product catalogues, financing schemes, and other tools to ensure that the indigenous innovation strategy results in the development of Chinese-owned technology and intellectual property (IP).

What qualifies as indigenous innovation?

At the end of 2006, the PRC Ministry of Finance (MOF), Ministry of Science and Technology (MOST), and National Development and Reform Commission (NDRC) jointly released Trial Measures for the Administration of the Accreditation of National Indigenous Innovation Products, which define the kinds of products that can receive indigenous innovation status (see Table). To qualify as an indigenous innovation, a product must

• Have been produced by an enterprise that has full ownership of IP in China either via its own technological innovation activities or because the Chinese enterprise, work unit, or citizen has, by legal means, obtained the China IP rights;
• Have a trademark that is owned by a Chinese company and registered in China;
• Embody a high degree of creativity and innovation—for example, a product that masters core technologies or improves product functions by applying new technologies; and
• Offer a high degree of reliability and dependable quality, with certification from the China National Certification Administration or its provincial departmental branches.

Accredited products are eventually listed in product catalogues that governments at various levels use to guide their procurement decisions.

Over the past three years, a few provincial and municipal governments have developed their own product catalogues, which include lists of products accredited as indigenous innovation. To date, very few products made at a foreign-invested facility have received accreditation. Of the 523 products listed in the Shanghai catalogue, only two are made by foreign-invested enterprises (FIEs)—and those are from Chinese-foreign joint ventures with majority Chinese ownership. Of Beijing’s 42 qualified products, just one comes from a foreign company. Moreover, some of these catalogues also restrict domestically made products from other provinces, though such restrictions may not be explicit. For example, Wuhan’s catalogue is largely comprised of local products from Wuhan and surrounding Hubei Province, though the catalogue does not explicitly limit eligibility to local products. It is unclear whether localities will keep their separate catalogues, as MOST is working on a national-level catalogue.

Indigenous innovation label benefit: Preference in government procurement

The primary and most explicit benefit conferred upon products that receive indigenous innovation recognition is preference in government procurement. The size of China’s government procurement market is difficult to calculate because schools, hospitals, museums, think tanks, state-owned enterprises, and other public entities are subject to varying degrees of influence from central and local governments. Even excluding these entities from the government procurement system, however, China’s vast government bureaucracy at the central and local levels presents substantial commercial opportunities across a wide range of industry sectors.

In addition to granting priority in government procurement, Selected Supporting Policies for the 2006-20 Medium and Long-Term Science and Technology Development Plan (2006) favor indigenous innovation products in price-based bidding. Article 23 states that during the price-based bidding process, if the price of an indigenous innovation product is higher than the prices of others, the company making the product may reduce the price in its bid; if the price is not higher than those of other products, the government agency must procure the indigenous product. In addition, several articles of the 2007 Evaluation Measures on Indigenous Innovation Products for Government Procurement give indigenous innovation products special treatment:

• Indigenous innovation products shall be given preference at a margin of 5-10 percent in the event that price is the sole determining factor (Article 13);
• Indigenous innovation products may enjoy an additional 4-8 percent boost in their technical and price evaluations if comprehensive evaluation methods are used (Article 14); and
• A government system for initial purchasing and ordering that will encourage the commercialization of products with indigenous innovation accreditation should be established (Article 24).

Potential problems and concerns for foreign companies

The biggest obstacle for foreign companies is the requirement that the applying China entity fully own the IP and first register the trademark in China. The primary concern of foreign companies is that they will be excluded from China’s government procurement market simply because they have developed IP and owned trademarks in other jurisdictions. Though many countries have government procurement policies that require a certain amount of local content, the current international norms for government procurement do not include IP ownership requirements.

Some companies are concerned about IP protection in China, but the bigger issue is structural: To remain competitive, companies must be able to sell their products and services globally rather than be restricted to selling only products that are based on IP developed in a particular market.

Many foreign companies have invested in China to serve the China market. In many cases, the parent company has licensed certain technology to its China subsidiaries to expand upon or develop new product for China, thereby bringing innovative products to China’s market, even if the patent or trademark itself is owned in another jurisdiction. New indigenous innovation regulations could therefore limit or slow the introduction of innovative products into China.

Recent developments

In late 2009, a series of PRC government agencies released two sets of documents related to indigenous innovation, raising questions and concerns from FIEs and prompting a response from foreign industry.

New rules for central-level indigenous innovation catalogue

MOF, MOST, and NDRC released two circulars in November 2009: application procedures and a notice that lays out provincial responsibilities for the new central-level indigenous innovation catalogue. The documents included a December 10, 2009 deadline for companies to submit applications for indigenous innovation status and a December 30, 2009 deadline for provinces to make recommendations to the central government for the scope of the catalogue.

Four of the six areas identified for inclusion in the indigenous innovation catalogue are information-technology related: computer and application devices, communication products (believed to include mobile phones), modern office equipment (such as digital copiers and cameras), and software. The remaining two are related to new-energy equipment and energy-efficient products. Foreign-company concerns center on Section IV of the application procedures, which reiterates seven conditions, including the patent and trademark restrictions that will likely exclude foreign companies’ products.

Catalogue lists industrial equipment products targeted for development

Several PRC agencies jointly released on December 29, 2009 a catalogue of industrial equipment products that they want domestic companies to develop to boost China’s equipment manufacturing industry. In addition to offering the usual mix of tax and financing incentives to assist domestic producers, the catalogue gives manufacturers of the listed equipment types priority in accrediting their products as national indigenous innovation products. The catalogue covers 240 types of equipment in 18 broad categories (see Box).

Listed equipment types will eventually be incorporated into the yet-to-be-released national-level Catalogue for Government Procurement of Indigenous Innovation Products. They can also receive preferential financing for product commercialization and be included in government-related research and development plans for science and technology products. Many of the types of equipment listed in the catalogue are being imported or developed by FIEs in China. Though the equipment catalogue does not explicitly exclude FIE products from receiving indigenous innovation accreditation, its references to indigenous innovation product catalogues and to recently issued qualification criteria for a national catalogue that effectively exclude FIEs raise concerns. In addition, the catalogue specifies an objective of import substitution, which is directed at replacing equipment imports from overseas suppliers with domestic products.

Draft implementing regulations for PRC Government Procurement Law

The State Council’s Legislative Affairs Office released on January 11, 2010 long-awaited draft Implementing Regulations on the Government Procurement Law—rules that outline the scope, responsibility, conditions, format, procedures, and requirements for government procurement in China. Notably, the draft defines domestic products, projects, and services in a way that appears to include FIEs.

Specifically, Article 10 of the draft implementing regulations defines a “domestic product” as one “made within China’s borders and for which domestic manufacturing costs exceed a certain percentage of the final price.” This definition should allow FIE products that pass a local content threshold—which apparently will be equally applied to Chinese-owned companies—to qualify as domestic for the purpose of government procurement. Though the draft is silent on the percentage of domestic content required to qualify as domestic, temporary measures released by MOF in 1999 stated that products with less than 50 percent of their value produced domestically were classified as imports. It is unclear whether these measures are still in effect.

Article 10 also states that government procurement for projects and services will apply to Chinese nationals, Chinese legal persons, or other Chinese organizations. Because FIEs have legal-person status under existing PRC laws, this definition indicates that projects and services provided by these FIEs should be treated as “domestic” for government procurement.

In addition, these regulations provide a threshold for the price preference to be given to domestic products and services. Many countries allow or require government entities to procure domestically produced items preferentially unless they are “unreasonably” expensive compared to a competing import. The draft regulations define “unreasonable commercial terms” to mean that the price of domestic goods, projects, or services is at least 20 percent higher than those of non-domestic competition. If a domestic offering meets this definition, it should not receive preference in procurement. (For reference, the US Buy American Provision in the American Recovery and Reinvestment Act has a threshold of 25 percent for manufactured goods, iron, or steel purchased under the act, and the United States has a 6 percent threshold for procured goods in general.)

Indigenous innovation is mentioned repeatedly throughout the draft regulations, reinforcing the notion that it is an increasingly important concept in the minds of PRC policymakers. Article 9 of the implementing regulations gives preference in government procurement to energy-saving and environmental-protection products, indigenous innovation products, products made by small and medium-sized enterprises, and products made in minority ethnic areas (such as Xinjiang). The article is significant because it states that qualifying products should either be given priority or mandatory purchase preferences, without further clarification. This article reinforces current concerns from foreign companies about criteria for qualification of indigenous innovation products that effectively exclude FIE participation.

Industry response

On December 10, 2009, 34 trade associations from Canada, Europe, Japan, South Korea, and the United States asked the PRC ministries to delay implementation of the November circulars and engage with industry on how to advance China’s science and technology goals and promote innovation through a fair and transparent selection process. The US government has also raised concern about the policy with the PRC government, with hopes that future policies and catalogues will reflect foreign-company concerns.

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Primary PRC Government Actors Managing Domestic Innovation

Several PRC government agencies are responsible for developing and implementing indigenous innovation policies.

• The State Council Leading Group on Science, Technology, and Education is comprised of representatives of major ministries and government offices, such as the ministries of Commerce, Finance (MOF), Industry and Information Technology (MIIT), and Science and Technology (MOST); the National Development and Reform Commission (NDRC); and the Chinese Academy of Social Sciences, among others. Led by PRC Premier Wen Jiabao, this group is responsible for discussing, reviewing, and approving major policies and strategies on science and technology (S&T) and coordinates relevant departments and localities to implement key tasks and projects. The group has been involved in formulating indigenous innovation policy since 2005 and is the principal venue for integrating indigenous innovation policy among the various agencies involved.
• MOST is responsible for leading the reform of China’s S&T system and formulating S&T strategies, policies, and laws and regulations. Responsible for China’s overall innovation strategy, MOST is tasked with accrediting indigenous innovation products and formulating and developing indigenous innovation product catalogues.
• NDRC is the PRC government’s chief ministry-level macroeconomic planning body. NDRC sets China’s long-term national economic development agenda, from which ministries derive and implement their own policies. Importantly, S&T and innovation are outgrowths of these long-term economic development policies.
• MOF oversees government procurement and sets procurement criteria for indigenous innovation products. Procurement is the lifeline of China’s indigenous innovation strategy, because government purchases are a major source of funding for companies engaged in the research and development of innovative products.
• MIIT is built around the core functions of the former Ministry of Information Industry, including regulation of electronics and information product manufacturing. It is also responsible for crafting and implementing China’s industrial policies, of which innovation is an essential component.

—US-China Business Council staff[/box]

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Industrial Equipment Products Targeted for Domestic Development, December 2009

According to the Catalogue Guiding Indigenous Innovation in Major Technology Equipment—released by the PRC ministries of Finance, Industry and Information Technology, and Science and Technology, and the State Asset Supervision and Administration Commission in December 2009—domestic companies are encouraged to develop and commercialize products in the following categories:

• Clean and efficient power-generating facilities;
• Ultra- and extra-high voltage (UHV/EHV) power transmission and transformation equipment;
• Large petroleum and chemical equipment;
• Large coal-chemical equipment in complete sets;
• Large high-precision metallurgical equipment in complete sets;
• Large coal and open-pit mining facilities;
• Railroad transportation equipment;
• Large environmental protection and resource management facilities;
• Large construction machinery;
• New textile machinery;
• New and large horsepower agricultural equipment;
• High-tech electronic, biology, and medical facilities;
• High-tech shipbuilding and oceanography engineering facilities;
• High-end numerical control lathes;
• Civilian aircraft;
• High-end printing equipment;
• Basic components and heavy castings and forgings for large industrial products; and
• Airport equipment and port machinery.

—US-China Business Council staff[/box]

[author]This article is adapted from the US-China Business Council (USCBC) issues brief, New Developments in China’s Domestic Innovation and Procurement Policies. USCBC, publisher of the China Business Review, provides extensive China-focused information, advisory and advocacy services, and events to more than 200 US corporations operating within the United States and throughout Asia. For the full report, .[/author]

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